IRS Should Fix Net Investment Tax Proposed Regulations

The Affordable Care Act created new taxes, including a Medicare 3.8% surtax on unearned income (including investments), starting in 2013, which applies to upper income taxpayers making over $250,000 (married) and $200,000 (single). Plus a 0.9% Medicare surtax on earned income is assessed over the same adjusted gross income thresholds. The 0.9% surtax brings the Medicare rate on earned income to the same 3.8% as on unearned income. Other taxes include a Medical Device Tax, Individual Mandate Non-Compliance Tax, High Medical Bills Tax, and Flexible Spending Account Tax.

In December 2012, Treasury released its proposed regulations, including detailed tax rules for the 3.8% Medicare surtax on unearned income. It’s also referred to as the net investment tax (NIT) on net investment income (NII).

When we first read the fairly short section covering the Medicare surtax on unearned income, we found it to be pretty straightforward and assumed all unearned income, loss and expense would be summarized and taxed just like the self-employment tax on earned income is summarized and taxed, now. There are no separate buckets or loss limitations in self-employment taxation on earned income.

That’s not what the tax attorneys from Treasury did with the Affordable Care Act’s NIT. They took the short code and turned it into a monster of proposed regulations. In my view, they made some unintentional errors.

Our biggest problem is that the proposed tax regulations could cause serious damage to traders and other taxpayers by limiting various types of losses and expenses from their NII calculations. For something that significant and material, the code should specifically state that losses will be limited in this fashion, but it does not.

Suppose a securities trader is married to an executive with a W-2 in the amount of $450,000. The trader has a trading business loss of $100,000, comprised of a Section 475 MTM ordinary trading loss of $75,000 (reported on Form 4797) and trading business expenses of $25,000 (reported on Schedule C). It doesn’t matter if the trading business is a sole proprietorship or a pass-through entity. The couple also has an investment long-term capital gain of $90,000, and interest and dividend income of $10,000. They have no investment expenses or investment interest expenses. Their married/filing joint AGI is $450,000, which represents the wife’s W-2 income, since all unearned income activity was at breakeven.

Based on our interpretation of the code, in this example all unearned income, loss and expense is zero, and NII matches unearned income or loss calculated in gross income. Even though the couple is over the $250,000 AGI limitation by $200,000, there is no NIT since there is no NII.

The proposed regulations create three different income-type buckets, and they limit each bucket to zero, not allowing buckets with net losses to be counted in NII. Here’s what those categories would look like for our example couple:

• Regulation bucket 2 is “other gross income from a trading business.” A strict interpretation of the proposed regulation shows the bucket 2 total is in the hundreds of thousands of income, because individual trading losses are carved out and placed into bucket 3. This happens whether the business trader uses Section 475 MTM or the cash method.

• Regulation bucket 3 is an investment capital gain of $90,000. But, after trading losses are moved from bucket 2, the loss is in the hundreds of thousands.

Do the math with the current proposed regulations. Bucket 1 would be $10,000. Bucket 2 would be $475,000, assuming there are $500,000 of trading gains on individual trades, less $25,000 of trading business expenses. Bucket 3 would be limited to zero since the $90,000 investment capital gain is offset with the business trading losses $575,000. TotalTotal NII would be $485,000.

If Treasury fixes the proposed regulations, bucket 1 would be $10,000, bucket 2 would be a revised loss of $100,000 and bucket 3 would be a revised gain of $90,000 from the investment capital gain. Revised NII would be $100,000 since only bucket 1 and 3 are positive and can be counted in NII.

Because NII is $485,000, we would use the lower amount of AGI over the AGI threshold: $200,000 times the 3.8% rate equals a NIT of $7,600. But if Treasury makes the bucket 2 loss-carve-out fix, revised NII will be $100,000 and it’s less than the excess of AGI over the threshold. NII of $100,000 times 3.8% equals $3,800 of NIT. The spouse already paid Medicare tax on her earned income of $450,000. The proposed regulations would cause them to pay Medicare tax on phantom unearned income.

While Treasury seems to have unofficially conceded the fix to stop carving out bucket 2 losing business trades and placing them into bucket 3 investments, we don’t think that goes far enough for traders. We want to do away with all buckets, and we don’t want buckets or items limited to zero. Losses should be allowed in full.

The Managed Futures Association (MFA) sent a letter to Treasury with its suggested fixes to these proposed regulations. It pointed out some of the same problems we have, and asked for the fix of losses carved out of bucket 2, along with other fixes, too. The goal is to combine all trading and capital gains and losses between buckets 2 and 3, so you don’t have a trader business loss isolated and lost in case you have investment capital gains – which happens in the above example. The MFA made a good point about this with hedge funds. It also asked for bucket losses not included in NII to be carried over to the subsequent year’s NII calculations.

We go a big step further. We want all items summed up as we read the code. We agree all losses not used in the current year’s NII calculations should be carried over to the subsequent year’s NII calculation, on par with capital losses. Capital loss limitations exist to pay for lower long-term capital gains rates. How can anyone justify loss limitations with NII and NIT?

We’re concerned Treasury will only make the bucket 2 loss carve out fix, which means we will still be left with disenfranchisement from using many unearned losses. In the big picture, that causes the most damage. That potential outcome is unacceptable for business traders using Section 475 MTM ordinary gain or loss treatment, because they likely won’t get a chance to deduct their potentially very large net trading losses from NII.

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